Dr. R.A.N.M ARTS AND SCIENCE COLLEGE�Affiliated to Bharathiar University , �Accredited with “ B+” NAAC�
Mrs. N. Geetha M.Com (CA)., Assistant Professor,� Department of Commerce (CA)
Course Name : Futures & Options
�Welcome You All
DERIVATIVES
Derivatives are financial contracts whose value is dependent on an underlying asset or group of assets. The commonly used assets are stocks, bonds, currencies, commodities and market indices. The value of the underlying assets keeps changing according to market conditions.
The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future.
Imagine that the market price of an equity share may go up or down. You may suffer a loss owing to a fall in the stock value. In this situation, you may enter a derivative contract either to make gains by placing an accurate bet. Or simply cushion yourself from the losses in the spot market where the stock is being traded
Types of Derivative Contracts
The four major types of derivative contracts are options, forwards, futures and swaps.
Options
Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time. The buyer is not under any obligation to exercise the option. The option seller is known as the option writer. The specified price is known as the strike price. You can exercise American options at any time before the expiry of the option period. European options, however, can be exercised only on the date of the expiration date.
Futures
Futures are standardised contracts that allow the holder to buy/sell the asset at an agreed price at the specified date. The parties to the futures contract are under an obligation to perform the contract. These contracts are traded on the stock exchange. The value of future contracts is marked to market every day. It means that the contract value is adjusted according to market movements till the expiration date.
Forwards
Forwards are like futures contracts wherein the holder is under an obligation to perform the contract. But forwards are unstandardised and not traded on stock exchanges. These are available over-the-counter and are not marked-to-market. These can be customised to suit the requirements of the parties to the contract.
Swaps are derivative contracts wherein two parties exchange their financial obligations. The cash flows are based on a notional principal amount agreed between both parties without exchange of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate. Interest rate swaps are the most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.
Swaps
Participants in derivatives market
Each type of individual will have an objective to participate in the derivative market. You can divide them into the following categories based on their trading motives
Hedgers
These are risk-averse traders in stock markets. They aim at derivative markets to secure their investment portfolio against the market risk and price movements. They do this by assuming an opposite position in the derivatives market. In this manner, they transfer the risk of loss to those others who are ready to take it. In return for the hedging available, they need to pay a premium to the risk-taker. Imagine that you hold 100 shares of XYZ company which are currently priced at Rs. 120. Your aim is to sell these shares after three months. However, you don’t want to make losses due to a fall in market price. At the same time, you don’t want to lose an opportunity to earn profits by selling them at a higher price in future. In this situation, you can buy a put option by paying a nominal premium that will take care of both the above requirements.
Speculators
These are risk-takers of the derivative market. They want to embrace risk in order to earn profits. They have a completely opposite point of view as compared to the hedgers. This difference of opinion helps them to make huge profits if the bets turn correct. In the above example, you bought a put option to secure yourself from a fall in stock prices. Your counterparty i.e. the speculator will bet that the stock price won’t fall. If the stock prices don’t fall, then you won’t exercise your put option. Hence, the speculator keeps the premium and makes a profit.
Margin traders
A margin refers to the minimum amount that you need to deposit with the broker to participate in the derivative market. It is used to reflect your losses and gains on a daily basis as per market movements. It enables to get leverage in derivative trades and maintain a large outstanding position. Imagine that with a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs 1000 each in the stock market. However, in the derivative market, you can own a three times bigger position i.e. Rs 6 lakhs with the same amount. A slight price change will lead to bigger gains/losses in the derivative market as compared to the stock market
Arbitrageurs
These utilize the low-risk market imperfections to make profits. They simultaneously buy low-priced securities in one market and sell them at a higher price in another market. This can happen only when the same security is quoted at different prices in different markets. Suppose an equity share is quoted at Rs 1000 in the stock market and at Rs 105 in the futures market. An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs 50
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